Thoughts from a guy who reached Financial Independence before 30

Brexit and Finance

What follows is not a political discussion on Brexit. Neither is it a debate on the merits of Brexit. If you get triggered reading the following, my best advice is to calmly breathe and close the browser window. Be forewarned, I will not approve any comments talking about ‘remainers’, ‘leavers’ or politics, so don’t waste your time. With that out-of-the-way, let’s get down to business.

A few weeks ago I met up with a friend of mine who is the finance director at a start-up. To say he looked tired and stressed would be an understatement. We talked about life and our families and then the subject turned to work. He clearly needed to get a lot off his chest. Because for him, Brexit is not some political Punch and Judy. It’s something he has to live and breathe every day as he wrestles every day with the fallout.

He’s not alone. Other finance and treasury-function people I talk to are having an equally tough time. For them, the frustration is as much the situation they are dealing with as it is that nobody is talking about it. Unfortunately, things such as Working Capital Financing, Currency Cash Flow Hedging and Cost of Capital Appraisal are not sexy. They don’t sell papers. But they have a huge hidden impact on our economy. My friend implored me: “Mr YFG! Please write about this!” So here I am, let’s give it a go.

A quick overview

The easiest way to see something is up is to have a look at the excellent Deloitte CFO Survey. Every quarter Deloitte interview roughly 100 or so CFOs of UK FTSE-listed and private companies asking them a range of questions. The headline figures are principally optimism and uncertainty. These being a kind of barometer to the inner workings in industry. The Q3 2018 report just came out and two figures jumped out to me:

The thing to take away from these two figures is not necessarily the overall levels of uncertainty and impact. Rather, what I think is important is the pattern – a distinctive ‘U shape‘. The peak in 2016 is understandable. A clear reaction to a sudden, momentous event. Over time, as we collectively got a better feel for what ‘Brexit’ was, uncertainty gradual ticked down. But over the past year, that trend has reversed.

That’s concerning because one would hope that as we got closer to the ‘day of reckoning’ we’d have a better collective understanding of what’s going to happen and plan accordingly. What this data tells me is that CFO’s are increasingly uncertain as we approach March 2019. Let’s have a look at three practical reasons why this is the case.

Treasury

The message I’m hearing loudest is that the biggest issue isn’t employees or regulations. It’s cash. This shouldn’t be surprising. It’s the first thing you learn in accounting. Cash is all important.

Banks are being increasingly difficult in lending money to Small and Medium-sized Enterprises (SMEs). Whereas a year or two ago refinancing may have been trivially easy, some banks are dragging their feet. Most are still lending, but they use crafty tricks to make things slightly more difficult. These range from arguing over minor clauses in agreements, insisting on extra guarantors/security, through to ratcheting up every covenant as high as possible. You might be thinking, so what? Well, all that arguing gums up companies. It slows business decisions down. The finance team has to add extra financial metrics to monitor. The CEO and CFO spend more days in meetings with banks and lawyers, less time running their companies. It’s a drag. It’s costly. It has the impact of reducing investment. (FWIW: I’m not suggesting for a moment the big banks were particularly nice to SMEs pre-Brexit either…)

Likewise, Private Equity and Venture Capitalists are also getting cold feet. Many are choosing to sit out and watch what happens rather than making big bets. Sure, there are still big deals in the news. But beneath those big deals are 1,000s of SMEs and dozens of deals that used to be done that ain’t. Again, some start-ups which once could blink and get VCs swooning now almost have to beg to get them to the table. It’s important to remember we’re not talking valuation here. I’m not saying businesses are worth less because of Brexit – because I don’t know that! It’s simpler than that. It’s more difficult just to get people talking about valuation in the first place!

Currency

The thing that’s driving my friend most loopy is currency. As a young gent, I was busy playing with my legos when Black Wednesday hit. That was over 25 years ago. Unless you’re over the age of 50, it’s a challenge to remember a time when Sterling wasn’t a strong and stable (sorry) currency. We’ve been spoiled for a long time. Now, we are seeing Sterling move as much as +/- 5% in a month.

We hear a lot about how we, as a country, have to import goods. That kind of abstraction hides all the goings-on behind the scenes. Sure, queues at ports are a concern. But right now, businesses are spending more time just trying to get goods in the first place. These things range from suppliers no longer accepting payment in Sterling, to banks jacking up the cost of currency hedges through to, perhaps worse of all, suppliers refusing to commit to long-term supply contracts.

These things make planning long-term budgets incredibly difficult. But they still have to be done. The banks demand them, the investors demand them, employees need to know management is looking out for the future of the business. Unfortunately, Brexit hasn’t magicked up any more accountants (as far as I’m aware, maybe you think that’s a good thing!).

My friend is having a particularly tough time as his company works in consumer goods. Almost all raw materials are costed in dollars, almost all sales in pounds. Whereas once upon a time working out cost per unit and margin was trivially easy, now it’s almost a day-by-day calculation. Again, that’s more time spent on short-term, tactical decisions; less time on long-term strategic ones.

Investment Appraisal

This is the area I’m most familiar with as it was/is my day job. I hope it’s not a leap at this point to say Brexit makes valuing businesses and projects more difficult. The impact of that is that where once a company might be able to make a big investment decision in a week/month, that decision now takes a month/year/not at all. This is not because Brexit may or may not make a business less valuable. If you’ve got two projects which are both expected to return £10m but one is doubly more uncertain than the other, you’ll invest in the more certain one. That’s common sense. Applied to business decision-making, when faced with more uncertain returns on projects, investments that you would have made before have now become too uncertain to invest in.

Just to reiterate, it’s kinda irrelevant whether Brexit ends up being the best (or worst) thing that’s ever happened to Britain. It’s the uncertainty that stifles investment. Going back to the port example that’s been touted around. The reason businesses are worried about that is not ‘the queues’, it’s hidden in the forecasts.

Let’s run through a hypothetical: say you’re a drinks company, looking to add smoothies to your product list. You buy the oranges in Euro from a farm in Valencia. Your margins, like most consumer goods businesses, are thin (you ain’t Nestle). Thankfully, you’ve got all your hedges in place (even if the cost is now double what it was before). As a small consumer goods business, you’ve been squeezing your working capital (net current assets) hard. You hold little inventory. You spend a great deal of time on cash collection and cycling as much of those sales back into operations as possible. Now, what if there is a one-day delay at the ports? Your little inventory dwindles, you get paid one-day later by your customers, but you still have to pay your supplier on time.

What about two-weeks? One-month? In those cases, that might be catastrophic for your company. It might also be catastrophic for your customers. It’s a flywheel. You are delayed, your customer is delayed. Everyone is delayed, you all get cash in later but still have bills to pay. Businesses run out of cash and go bust.

That risk went up from almost 0% before, to non-zero with Brexit. It probably won’t happen. In fact, it’s very likely not to happen (I surmise). But as a company owner, you have a duty to your employees, your customers, your suppliers to consider it. Over the long-term, your new smoothie business might make loads of money in the forecast. Demand for Valencia Orange smoothies surges (perhaps due to fewer Brits going on holiday to Spain). But that doesn’t matter if you run out of cash! So you might decide to hold back on investment. So too do the 10,000s of other SMEs up and down the country. That has a knock-on impact on the long-term growth of the country. And that’s why even such a ‘small’ thing such as queues at a port can be so important. It’s those hidden multiplicative effects.

Summarising

I’ve focused on three things here – Treasury, Currency and Investment Appraisal. Many people would argue there are more important issues: hiring employees, consumer demand, tariffs. Those things are ubiquitous in the media. Those things are more tangibly obvious. I also wanted to give a peek into some of the things which are less often (never) talked about, but still matter, and show why they matter.

I know I’ve said this many times, but I will say it one final time. These things don’t turn on whether Brexit is a success or not. It’s, in some ways, irrelevant whether over the long-term Brexit is a good thing for Britain. These things turn on the uncertainty associated with any big change in economic direction of a society. They are important because hidden away, these effects multiply and can have an enormous impact on our businesses and economy. Unfortunately, that is lost in the shambolic political discourse of this country.

[A reminder: feel free to leave a comment. I would particularly like to hear from you if you own or work for an SME or start-up, I’m always very interested to hear from different viewpoints. However, I will not approve comments that talk politics or leavers/remainers or the usual Brexit fare. There are plenty of places to have those discussions, here is not one of them.]

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11 thoughts on “Brexit and Finance”

I think many companies are having a hard time managing uncertainty because they are over leveraged or living hand to mouth.

When I was a co-owner-manager of a circa £10M turnover company we managed currency by holding reserves (payments we received from overseas clients) in euros and dollars. We only converted to GBP when conditions were favourable. Holding foreign currency also enabled us to buy from US and EU suppliers if there were savings to be had.

We managed cashflow by holding a £1M+ cash buffer, accumulated by not being greedy. In 15 years we borrowed £0 from the banks. We paid suppliers on time and only recognised profit when contracts were completed.

So cash is king and always has been. Allows for great flexibility and stability.

As the company grew accountants (my co-owners were all engineers) tried to convice us that we should extract more cash and use financing.

We resisted as we liked to sleep at night and were mistrustful of ‘clever’ accounting

Over leveraged companies are like tightly tuned racing cars, sometimes they perform well, but quite often the blow up.

We have now sold the company, the new owners, a large corporate – pay suppliers late, recognise revenue prematurely using some WIP nonsense and fret about net working capital constantly.

The uncertainty of Brexit will surly expose companies that are trading on the edge, possibly your friend’s start-up is like this. I don’t think it is just Brexit but also cheap credit has created an a life support environment for zombie companies. As credit dry’s up start-up failures will increase and maybe some larger names will go to the wall. Its not all bad news, maybe its time there was a good clear-out.

If we still owned the company, we would not have been worried about Brexit because of the very conservative way it was run. Maybe I am naïve but the financial system would be more stable if there was less debt and both companies and people lived within their means.

On a personal level the uncertainty of Brexit has affected my investing. I have a chunk of cash and am not sure what to do. Do I invest in global stocks in case GBP falls, or wait in case GBP rallies – all depends on the outcome of negotiations. I hate uncertainty. I do know that whatever I think will happen that the opposite will happen. It not a question BTW because nobody knows the answer.

I don’t think things have really ever fully recovered for SMEs since 2008, and some of the systemic problems are still there due to cheap credit and zombie companies. As interest rates and tax burdens rise I think we will see more companies struggling and going bust. All we can do is keep smashing money into those index funds and avoid trying to time the markets.

While I agree that Brexit is creating uncertainty and having an impact on lending, I would also say that it just exacerbates the trend since 2008. The regulatory environment for bank lending has become increasingly punitive toward corporates and SMEs. When banks can hold Gilts at 0% RWA, residential mortgages at 50% but SME lending is at say 125%, then the hurdle rate for commercial banks to lend with micro-enterprises or SMEs will clearly rise. I just can’t see any good business reason for banks to lend to risky SMEs. We’re forcing an increased proportion of SME lending into the shadow banking/alternative investment arena. Hence the rise of P2P, for example.

To this trend, you also have to add the reality that we are now late cycle. We’ve had artificially benign credit conditions since 2008. Default rates are already turning higher. No prudent lender should be increasing leverage this late in the cycle. Instead they should be using more punitive covenants to protect their interests, refusing more borrowers. Private equity and VC also should get more cautious since they know their ability to exit prior to the next downturn becomes more difficult the later in the cycle they invest.

With regard to currency fluctuations, Brexit clearly creates a difficult gap risk. Currency volatility, however, has not risen; in fact it remains below long term averages. In reality, GBP has always been higher volatility currency given our balance of payments. Nonetheless, most moves are actually driven by the US$. For example, the 10% move from 1.43 to 1.28 in GBP/USD this year, 7% was simply a move in the US$ index. Moreover, it’s never been easier to hedge this risk using currency forwards. I haven’t seen any increase in the cost of FX hedging; it’s virtually negligible in bid/offer (2bp). Unfortunately (or fortunately depending on which side of the fence you sit on), the treasury functions of smaller companies remain borderline clueless on how to manage fx risk and continue to pay margins of 50bp or even 100bp for risks that can be instantly hedged for

The distortions in the credit market have certainty exacerbated the issue. In fact, it’s hard to say where you can draw the line (if there is one) between all the various factors. I’m definitely nowhere near smart enough to know. I’m sure opinions abound.

That ties into the recent Howard Mark’s memo (which I read this week). The line that stood out for me was: “[The Crisis of 2007-08 was caused by financial engineering.] In other words, not securities and debt instruments themselves, but the uses to which they put.” I suspect, though I wasn’t around then to tell you, the same could very much be said about the dot-com bubble!

Talking about cycles, I don’t know if we’re late in the cycle or not. I did, however, see a very depressing chart doing the rounds a few weeks ago which showed that, despite being 10+ years into this cycle, real gdp growth is still in single digits (compared to 10/20/30+% over all other periods, except the post war crash). If we truly are late in cycle, real growth has been ephemeral.

All that said, I’m completely on board with banks tightening their braces. Less so on PE houses. Of course, vintages late in cycle *should* be more cautious, but that *should* be reflected in valuation (he says, well aware that that doesn’t happen!).

I’ll very much defer to you ZX on hedging (having neither worked treasury or in banking and you very much know your onions!). On that note, do you think there are valid reasons for why companies would pay such wide margins on their hedges? Or do you think there is some kind of collective failure on the part of these companies as a group?

What has changed is technology. Go back 20 years (or even 10) and the process of doing FX hedging was highly manual. You rang up your business bank manager, he rang the retail fx desk, they quoted him a price. The price was often wide because interbank the minimum trade size was say £1mm and hedges smaller than this had to be accumulated (or netted) until that min size was reached. Thus the dealer ran the gap risk and charged accordingly.

Now we have a vast array of e-platforms all with STP etc. Algos sit behind the platforms and no human touches the system unless the market gets disorderly. You can trade any size down to say £100. I can trade £10mm of GBP/USD at say 1.315-1.31503 i.e. 0.3 pips wide (0.0023% bid/offer), 24 hours a day with a double click.

Unfortunately, most business banking hasn’t moved on at all. It’s rarely connected into these platforms and remains highly manual. Many SMEs lack the confidence to set up accounts at FX brokers and do these deals themselves. They don’t always understand what FX hedging really means. It’s basically inertia, poor education etc.

Thanks ZX, I’m very thankful for this blog as I’ve been able to learn lots about things I knew little or nothing about. It sounds a bit like a “this is the way we’ve always done it” attitude. Then again, I’m sure all industries and jobs have elements of that to some extent!

Interesting observations on uncertainty delaying/paralysing investment and resource allocation decisions, and also on business cycles.

I’m seeing a similar pattern in the IT sector. Normally clients have a long wish list of projects and programmes they wish to conduct, which are constrained by budgetary and prioritisation limitations.

This year I’m seeing the opposite. The forward work pipeline at many sites is virtually empty, with all non-regulator or non “burning platform” work kicked far into the long grass.

The 30,000 foot view programme managers and architects who would normally be plotting and scheming the scope and size of future work programmes are instead finding themselves on the bench, hearing the sound of crickets when they tap their networks for their next role.

With nothing in the pipeline, this will see the analysts, developers and testers joining them early next year as their current engagements conclude.

Supply and demand will likely see job numbers, day rates, and salaries all drop as a result.

Even if Brexit turns out to be a smashing success, it takes time to incept and size new work programmes. The uncertainty in decision making today will make for an uncomfortable couple of years for many.

In terms of job market impact, I would agree this feels a lot more like the dot-com crash than the GFC.

Hi Indeedably, that doesn’t surprise me either as Mrs YFG and our legal friends are seeing the same things in their lines of work – a focus on tying up existing business and kicking things in the long grass. Hopefully, it’s not too long-lasting – the similar cool-down before and after the referendum quickly picked up. My concern is that these kinds of actions don’t appear in the statistics and only start to be felt a few years down the line when that lack of investment kicks in – thus my concern when I see the ‘u shape’ in the data.

Thank you for this very thought provoking article. If uncertainty is the mother of financial weakness, then should we conclude that once Brexit arrives, good or bad, we would do better? Go long Britain in Q2 2019 based on elimination of doubt, since financial markets discount the future? Or should we expect a long, drawn out, period of niggling little fights over the rules? And, if one does expect the end of uncertainty to be a positive, how would one go long Britain? It is no longer a simple go long GBP, since ZXSpectrum48K has correctly pointed out that currency moves have been almost entirely a result of the strong dollar.
One more thing: From your charts, the time it took to get from “There Will Be Uncertainty” to “I need to be careful with my money” was over a year in Britain. It has not yet been a year since the start of the “Tariff Skirmish” between the US and China. I wonder if continuing uncertainty about trade will soon cause CEO expectations to play out the same way in the US and China.